10/25/2007 @ 6:00PM

Adam Smith's Folly

Were Adam Smith alive today, he’d be an activist hedge fund manager or a private equity raider. He had a decidedly pessimistic view about corporations. Most businesses of his day were proprietorships or partnerships. He didn’t think corporations–joint-stock companies, as they were then called–would amount to much, because badly incentivized managers would inevitably destroy them.

“The directors of such companies … being the managers rather of other people’s money rather than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which [they would] watch over their own,” he wrote. “Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”

In other words, managers are invariably prone to waste. They will gold-plate their office equipment and cut out early for their kids’ music recitals. And what about stockholder fraud, such a large source of angst among modern governance critics? Smith felt that the possibility of theft existed in every area of commercial life, yet commerce thrived. “Negligence and profusion,” what economists now call “agency costs,” were different; they were, and are, an inherent result of the separation of ownership and management.

Smith was well aware of the benefits of corporations, including their ability to concentrate large amounts of money into capital-intensive undertakings. But he thought that the costs of agency would always be too high. He believed that those costs scaled up with the business, as that was the experience of his day. Therefore, the bigger a business got, the worse the waste. He frankly didn’t see any way around it, even if the corporation had monopoly privileges.

“It is upon this account that joint-stock companies for foreign trade have seldom been able to maintain the competition against private adventurers. They have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one,” wrote Smith.

Early corporations were chartered by the Crown or legislature. In the days before corporate income taxes, this was a novel way for a government to raise revenue. The monarch would grant a corporation special trading rights or other monopoly privileges in return for certain payments. The Crown might even invest money in this enterprise for a share of its dividends, or expect these enterprises to lend large sums to the government at favorable rates. The incestuous relationship between government and corporations no doubt colored Smith’s view of these kinds of businesses.

Why was Smith so far off the mark on the survivability of corporations? For one thing, the relationship between corporations and the state has since transformed. Although the incestuous quid pro quo that was prominent in Smith’s day remains the norm in most of the world, it’s not typical in developed economies. Most western corporations operate without any special privileges, under licenses that are routinely offered to anyone willing to go through some simple administrative processes. The resulting lack of special treatment from the government forces corporations to become ever more competitive in minimizing unnecessary costs, including agency costs.

Nominally, the main tool for controlling agency costs has been board oversight. However, Smith was no more confident in the efficacy of that control than were many subsequent critics of boards, with good reason. Boards get fooled all the time, and they have their own issues with greed. The dramatic reduction in agency costs that made corporations feasible was, in fact, brought about by the development of two other, powerful tools that Smith did not foresee: transparency and internal incentives.

In the 19th century, railroads were the biggest promise of corporations–and the biggest challenge to their existence. Railroads were capital-intensive and operated on such a large scale that no central committee could supervise its operations. Money flowed in and out of the business through countless retail transactions. Railroads were ungovernable by any standards of Adam Smith’s time. But the new technology spawned new kinds of organization, and new governance mechanisms to cope with it.

The Baltimore and Ohio (B&O), the first of the big railroads, pioneered a new level of transparency. It began with a five-page letter from the president to the investors in their first year of construction. Three years later, it had grown to a 153-page letter with 15 tables of actual vs. budgeted construction costs. After they began operations, B&O management provided revenues by station and expenses by month, as well as net income and cash flow. Nobody told B&O’s managers that they had to do it–not the government or the stockbrokers or “good governance” critics. Their managers simply figured that if they wanted the cash needed to grow the businesses, they needed to make their investors as comfortable as possible.

A little later, corporations discovered sophisticated managerial incentives. Early in the growth of Standard Oil, John D. Rockefeller offered stock to his senior managers so they would think of themselves as partners in the enterprise. Alfred Sloan developed an innovative profit-sharing plan for his managers that effectively aligned their interests with that of General Motors‘
shareholders without diluting their equity. Management incentives eventually evolved into tools for motivating even lower-level employees to work hard for the shareholders. Notwithstanding the paternalism of capitalists in his day, Smith could not foresee a sales manager and her family being sent to Aruba for winning a sales contest. How could any company afford to be so generous? Why would they give something like that away? Where is Aruba?

Adam Smith will go down in history as one who foresaw innumerable ways that market processes could adapt and organize themselves to allocate scarce resources between economic agents. He would be quite comfortable–and mighty pleased–with the dizzying scope of trade in every commodity, product and service imaginable, and the incredible wealth engendered by that trade. He predicted that. But he would be surprised by the degree to which economic agents themselves would evolve, that they could scale up dramatically while keeping their agency costs well under control. After realizing how utterly wrong he was about corporations, Smith would probably nod in satisfaction. Or, maybe he’d buy them out and fire the managers.

Marc Hodak is managing director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance. He teaches corporate governance at New York University’s Leonard N. Stern School of Business.